THE NATURE OF THE NATURE OF INDUSTRYINDUSTRY

THE NATURE OF THE NATURE OF INDUSTRYINDUSTRY

INTRODUCTION

• Several factors affect decisions such as how much to produce, what price to charge, how much to spend on R&D, advertising etc.

• No single theory or methodology provide managers answers to these questions

• Pricing strategy/ advertising etc. for a car maker will differ from food manufacturers

• In this section we examine the important differences that exists among industries.

Approaches to Studying Industry

• The Structure-Conduct-Performance (SCP) Paradigm:

• Different structures lead to different conducts and different performances

Market Structure

Refers to factors such as 1. The number of firms that compete in a

market, 2. The relative size of the firm

(concentration) 3. Technological and cost conditions4. Ease of entry or exit into industry

Different industries have different structures that affect managerial decision making (Structural differences)

1. Firm Size:Some industries naturally give rise

to large firms than do other industries:

e.g. Industry = Aerospace, Largest firm = Boeing

Industry = Computer, office equipment

Largest firm = IBM

2. Industry concentration:Are there many small firms or only a

few large ones? (competition or little competition?)

2 ways to measure degree of concentration:a. Concentration ratiosb. Herfindahl-Hirschman Index (HHI)

Concentration ratios measure how much of the total output in an industry is produced by the largest firms in that industry.

Most common one used is the four-firm concentration ratio (C4) = the fraction of total industry sales produced by the 4 largest firms in the industry

If industry has very large number of firms, each of which is small, then is close to 0

When 4 or fewer firms produce all of industry output, is close to 1

• Four-Firm Concentration Ratio– The sum of the market shares of the top four

firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales

– The closer C4 is to zero, the less concentrated the industry .

e.g. Industry has 6 firms. Sales of 4 firms = $10 and $5 for the other 2.

ST = 50

C4 = 40/50 = 0.8

4 largest firms account for 80% of total industry output

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i

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• Herfindahl-Hirschman Index (HHI)– The sum of the squared market shares of

firms in a given industry, multiplied by 10,000 (to eliminate decimals):

– By squaring the market shares, the index weights firms with high market shares more heavily

– HHI = 10,000 wi2, where wi = Si/ST.

0 <= HHI <= 10,000Closer to 0 means industry has numerous

infinitesimally small firms. Closer to 10,000 means little competition

HHI example3 firms in an industry. 2 have sales of $10

each and the other with $30 sales.Total Industry Sales = $50

1

440050

10

50

10

50

3010000

4

222

C

HHI

Since the top three firms account for all industry sales

Limitation of Concentration Measures

• Market Definition: National, regional, or local?

• Global Market: Foreign producers excluded.

• Industry definition and product classes.

• Market Definition: National, regional, or local? If there are 50 same size gas stations in the US, one in each state, each firm will have 1/50 market share. C4 = 4/50 market for gas is not highly concentrated. What good is this to a consumer in Blaine, Washington, since the relevant market is her local market?

• Geographical differences among markets lead to biases in concentration measures

Global Market: Foreign producers excluded.This tends to overstate the true level of

concentration in industries in which significant number of foreign producers serve the market

e.g. C4 for beer producers in US = 0.9 but this ignores the beer produced by many breweries in Mexico, Canada, Europe etc. The C4 based on both imported and domestic beer would be considerably lower

Industry definition and product classes:There is considerable aggregation across

product classes.e.g. Soft drink industry is dominated by

Pepsi and Coca-Cola yet the C4 for 2004 is 47%.

Quite low. The C4 contains many types of bottled and canned drinks including lemonade, iced tea, fruit drinks etc.

3. TECHNOLOGY• Some industries are labor intensive

while others are capital intensive• In some industries, firms have access to

identical technologies and therefore similar cost structures

• In others, only 1 or 2 firms may have superior technology giving them cost advantages over others

• Those with superior technology will completely dominate the industry

4. Demand and Market Conditions

• Markets with relatively low demand will be able to sustain only few firms

• Access to information vary from industry to industry

• Elasticity of demand for products tend to vary from industry to industry

• Elasticity of demand for a firm’s product may differ from the market elasticity of demand for the product

Markets where there are no close substitutes for a given firm’s product, elasticity of demand for the firm’s product will be close to that of the market

Rothschild Index = R =Et/Ef

Et = market elasticityEf = firm’s elasticity

Measures how sensitive a firm’s demand is relative to the entire market.

When industry has many firms each producing a similar product, R will be close to zero

5. Potential for EntryEasier for new firms to enter some

industries than other industries.Barriers to entry:• Explicit cost of entering (Capital

requirements• Patents• Economies of scale: new firms cannot

generate enough volume to reduce average cost

CONDUCT: Conduct (behavior) of firms

differ across industries1. Some industries charge a higher

markup than others. (pricing behavior)

2. Some industries are more susceptible to mergers or takeovers

3. Amount spent on R&D tend to vary across industries

1. Pricing behavior:Lerner Index (L) = (P – MC)/MCGives how firms in an industry mark

up their prices over MC.If firms vigorously compete, L is

close to zero.P = (1/1-L)MCWhen L=2 firms charge price that

is 2x the MC of productione.g Tobacco industry. L = 76% P

is 4.17x the actual MC of production

Lerner Indices & Markup Factors

Industry Lerner Index Markup Factor

Food 0.26 1.35

Tobacco 0.76 4.17

Textiles 0.21 1.27

Apparel 0.24 1.32

Paper 0.58 2.38

Chemicals 0.67 3.03

Petroleum 0.59 2.44

Source: Baye and Lee, NBER working paper # 2212

2. Integration and Merger ActivityUniting productive services.Can result from an attempt by firms

to• Reduce transaction cost• Reap the benefits of economies of

scale and scope• Increase market power• Gain better access to capital

markets

3 types of integration:

Vertical Integration: Various stages in the production of a

single product are carried out by a single firm

e.g. Car manufacturer produces its own steel, uses the steel to make car bodies and engines.

Reduces transaction cost

Horizontal Integration:Merging production of similar products

into a single firme.g. 2 banks merge to form one firm to

enjoy cost savings of economies or scale or scope and enhance market power.

When social benefits of this merger is relatively small compared to social cost of concentrated industry, government may block this type of merger

US Department of Justice considers industries with HHI > 1800 to be highly concentrated and may block any merger that will increase the HHI by more than 100

HHI < 1000 are considered unconcentrated.

3. Conglomerate MergersIntegrating different product lines into a

single firmCigarette maker acquires a bread

manufacturing firm.

This is to reduce the variability of firm’s earnings due to demand fluctuations and to enhance the firm’s ability to raise funds in the capital market

Performance

• Performance refers to the profits and social welfare that result in a given industry.

• Social Welfare = CS + PS– Dansby-Willig Performance Index

measure by how much social welfare would improve if firms in an industry expanded output in a socially efficient manner.

Approaches to Studying Industry

• The Structure-Conduct-Performance (SCP) Paradigm: Causal View

Market Structure

Conduct Performance

e.g. Consider a highly concentrated industry. This structure

gives market power enabling them to charge higher prices for their products. This conduct (behavior of charging higher prices ) is caused by the market structure (few competitors). The high prices cause higher profits and poor performance (low social welfare)

Thus, a concentrated market causes high prices and poor performance

• The Feedback Critique– No one-way causal link.– Conduct can affect market

structure.– Market performance can affect

conduct as well as market structure.

PRICING STRATEGIES OF FIRMS WITH MARKET

POWER

I. Basic Pricing Strategies– Monopoly & Monopolistic Competition – Cournot Oligopoly

II. Extracting Consumer Surplus– Price Discrimination Two-Part Pricing– Block Pricing Commodity Bundling

III. Pricing for Special Cost and Demand Structures– Peak-Load Pricing Price Matching– Cross Subsidies Brand Loyalty– Transfer Pricing Randomized Pricing

IV. Pricing in Markets with Intense Price Competition

Standard Pricing and Profits for Firms with Market Power

Price

Quantity

P = 10 - 2Q

10

8

6

4

2

1 2 3 4 5

MC

MR = 10 - 4Q

Profits from standard pricing= $8

An Algebraic Example

• P = 10 - 2Q• C(Q) = 2Q• If the firm must charge a single price to

all consumers, the profit-maximizing price is obtained by setting MR = MC.

• 10 - 4Q = 2, so Q* = 2.• P* = 10 - 2(2) = 6.• Profits = (6)(2) - 2(2) = $8.

A Simple Markup Rule• Suppose the elasticity of demand for

the firm’s product is EF.• Since MR = P[1 + EF]/ EF.• Setting MR = MC and simplifying

yields this simple pricing formula:P = [EF/(1+ EF)] MC.

• The optimal price is a simple markup over relevant costs!– More elastic the demand, lower markup.– Less elastic the demand, higher markup.

An Example• Elasticity of demand for Kodak film is -

2.

• P = [EF/(1+ EF)] MC

• P = [-2/(1 - 2)] MC• P = 2 MC• Price is twice marginal cost.• Fifty percent of Kodak’s price is margin

above manufacturing costs.

Markup Rule for Cournot Oligopoly

• Homogeneous product Cournot oligopoly.• N = total number of firms in the industry.

• Market elasticity of demand EM .

• Elasticity of individual firm’s demand is given by EF = N x EM.

• Since P = [EF/(1+ EF)] MC,

• Then, P = [NEM/(1+ NEM)] MC.

• The greater the number of firms, the lower the profit-maximizing markup factor.

An Example• Homogeneous product Cournot

industry, 3 firms.• MC = $10.• Elasticity of market demand = - ½.• Determine the profit-maximizing price?

• EF = N EM = 3 (-1/2) = -1.5.

• P = [EF/(1+ EF)] MC.

• P = [-1.5/(1- 1.5] $10.• P = 3 $10 = $30.

First-Degree or Perfect Price Discrimination

• Practice of charging each consumer the maximum amount he or she will pay for each incremental unit.

• Permits a firm to extract all surplus from consumers.

Perfect Price DiscriminationPrice

Quantity

D

10

8

6

4

2

1 2 3 4 5

Profits*:.5(4-0)(10 - 2)

= $16

Total Cost* = $8

MC

* Assuming no fixed costs

Caveats:• In practice, transactions costs and

information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).

• Price discrimination won’t work if consumers can resell the good.

Second-Degree Price Discrimination

• The practice of posting a discrete schedule of declining prices for different quantities.

• Eliminates the information constraint present in first-degree price discrimination.

• Example: Electric utilities

Price

MC

D

$5

$10

4Quantity

$8

2

Third-Degree Price Discrimination

• The practice of charging different groups of consumers different prices for the same product.

• Group must have observable characteristics for third-degree price discrimination to work.

• Examples include student discounts, senior citizen’s discounts, regional & international pricing.

Implementing Third-Degree Price Discrimination

• Suppose the total demand for a product is comprised of two groups with different elasticities, E1 < E2.

• Notice that group 1 is more price sensitive than group 2.

• Profit-maximizing prices?

• P1 = [E1/(1+ E1)] MC

• P2 = [E2/(1+ E2)] MC

An Example• Suppose the elasticity of demand for

Kodak film in the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5.

• Marginal cost of manufacturing film is $3.

• PU = [EU/(1+ EU)] MC = [-1.5/(1 - 1.5)] $3 = $9

• PJ = [EJ/(1+ EJ)] MC = [-2.5/(1 - 2.5)] $3 = $5

• Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.

Two-Part Pricing

• When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.

• Two-part pricing consists of a fixed fee and a per unit charge.– Example: Athletic club memberships.

How Two-Part Pricing Works

1. Set price at marginal cost.2. Compute consumer

surplus.3. Charge a fixed-fee equal

to consumer surplus.

Quantity

D

10

8

6

4

2

1 2 3 4 5

MC

Fixed Fee = Profits = $16

Price

Per UnitCharge

Block Pricing• The practice of packaging multiple

units of an identical product together and selling them as one package.

• Examples– Paper.– Six-packs of soda.– Different sized of cans of green

beans.

An Algebraic Example

• Typical consumer’s demand is P = 10 - 2Q

• C(Q) = 2Q• Optimal number of units in a package?• Optimal package price?

Optimal Quantity To Package: 4 Units

Price

Quantity

D

10

8

6

4

2

1 2 3 4 5

MC = AC

Optimal Price for the Package: $24

Price

Quantity

D

10

8

6

4

2

1 2 3 4 5

MC = AC

Consumer’s valuation of 4units = .5(8)(4) + (2)(4) = $24Therefore, set P = $24!

Costs and Profits with Block Pricing

Price

Quantity

D

10

8

6

4

2

1 2 3 4 5

MC = AC

Profits = [.5(8)(4) + (2)(4)] – (2)(4)= $16

Costs = (2)(4) = $8

Commodity Bundling• The practice of bundling two or

more products together and charging one price for the bundle.

• Examples– Vacation packages.– Computers and software.– Film and developing.

An Example that Illustrates Kodak’s Moment

• Total market size for film and developing is 4 million consumers.

• Four types of consumers– 25% will use only Kodak film (F).– 25% will use only Kodak developing (D).– 25% will use only Kodak film and use

only Kodak developing (FD).– 25% have no preference (N).

• Zero costs (for simplicity).• Maximum price each type of consumer will

pay is as follows:

Reservation Prices for Kodak Film and Developing by Type

of Consumer

Type Film DevelopingF $8 $3

FD $8 $4D $4 $6N $3 $2

Optimal Film Price?

Type Film DevelopingF $8 $3

FD $8 $4D $4 $6N $3 $2

Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2 million = $16 Million.

At a price of $4, only types F, FD, and D will buy (profits of $12 Million).

At a price of $3, all types will buy (profits of $12 Million).

Optimal Price for Developing?

Type Film DevelopingF $8 $3

FD $8 $4D $4 $6N $3 $2

Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.

At a price of $6, only “D” type buys (profits of $6 Million).

At a price of $4, only “D” and “FD” types buy (profits of $8 Million).

At a price of $2, all types buy (profits of $8 Million).

Total Profits by Pricing Each Item Separately?

Type Film DevelopingF $8 $3

FD $8 $4D $4 $6N $3 $2

Total Profit = Film Profits + Development Profits = $16 Million + $9 Million = $25 Million

Surprisingly, the firm can earn even greater profits by bundling!

Pricing a “Bundle” of Film and Developing

Consumer Valuations of a Bundle

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

What’s the Optimal Price for a Bundle?

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

Optimal Bundle Price = $10 (for profits of $30 million)

Peak-Load Pricing• When demand during

peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.

• Charge a higher price (PH) during peak times (DH).

• Charge a lower price (PL) during off-peak times (DL). Quantit

y

Price MC

MRL

PL

QL QH

DH

MRH

DL

PH

Cross-Subsidies

• Prices charged for one product are subsidized by the sale of another product.

• May be profitable when there are significant demand complementarities effects.

• Examples– Browser and server software.– Drinks and meals at restaurants.

Double Marginalization• Consider a large firm with two divisions:

– the upstream division is the sole provider of a key input.– the downstream division uses the input produced by the

upstream division to produce the final output.

• Incentives to maximize divisional profits leads the upstream manager to produce where MRU = MCU.– Implication: PU > MCU.

• Similarly, when the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MRD = MCD.– Implication: PD > MCD.

• Thus, both divisions mark price up over marginal cost resulting in in a phenomenon called double marginalization.– Result: less than optimal overall profits for the firm.

Transfer Pricing

• To overcome double marginalization, the internal price at which an upstream division sells inputs to a downstream division should be set in order to maximize the overall firm profits.

• To achieve this goal, the upstream division produces such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd):

NMRd = MRd - MCd = MCu

Upstream Division’s Problem

• Demand for the final product P = 10 - 2Q.• C(Q) = 2Q.• Suppose the upstream manager sets MR

= MC to maximize profits.• 10 - 4Q = 2, so Q* = 2.• P* = 10 - 2(2) = $6, so upstream

manager charges the downstream division $6 per unit.

Downstream Division’s Problem

• Demand for the final product P = 10 - 2Q.• Downstream division’s marginal cost is

the $6 charged by the upstream division.• Downstream division sets MR = MC to

maximize profits.• 10 - 4Q = 6, so Q* = 1.• P* = 10 - 2(1) = $8, so downstream

division charges $8 per unit.

Analysis• This pricing strategy by the upstream

division results in less than optimal profits!• The upstream division needs the price to

be $6 and the quantity sold to be 2 units in order to maximize profits. Unfortunately,

• The downstream division sets price at $8, which is too high; only 1 unit is sold at that price.– Downstream division profits are $8 1 – 6(1) = $2.

• The upstream division’s profits are $6 1 - 2(1) = $4 instead of the monopoly profits of $6 2 - 2(2) = $8.

• Overall firm profit is $4 + $2 = $6.

Upstream Division’s “Monopoly Profits”

Price

Quantity

P = 10 - 2Q

10

8

6

4

2

1 2 3 4 5

MC = AC

MR = 10 - 4Q

Profit = $8

Upstream’s Profits when Downstream Marks Price Up to $8

Price

Quantity

P = 10 - 2Q

10

8

6

4

2

1 2 3 4 5

MC = AC

MR = 10 - 4Q

Profit = $4DownstreamPrice

Solutions for the Overall Firm?

• Provide upstream manager with an incentive to set the optimal transfer price of $2 (upstream division’s marginal cost).

• Overall profit with optimal transfer price:8$22$26$

Pricing in Markets with Intense Price Competition

• Price Matching– Advertising a price and a promise to match any lower

price offered by a competitor.– No firm has an incentive to lower their prices.– Each firm charges the monopoly price and shares the

market.

• Randomized Pricing– A strategy of constantly changing prices.– Decreases consumers’ incentive to shop around as

they cannot learn from experience which firm charges the lowest price.

– Reduces the ability of rival firms to undercut a firm’s prices.

Conclusion• First degree price discrimination, block pricing,

and two part pricing permit a firm to extract all consumer surplus.

• Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.

• Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.

• Different strategies require different information.